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I Accept Larry White’s Correction…

I accept Larry White’s correction with respect to the word “liquidity.” The conventional language — that we distinguish between situations in which organizations are illiquid and those in which organizations are insolvent — is, I think, confusing at some level. After all, if there is no doubt that some organization is solvent why should it ever be illiquid? In an extreme, its own paper would be good enough. I think that what we usually call “liquidity” is actually made up of two different things — call them “duration” and “information.” Assets that mature in the future are illiquid in that they have unusually low prices today to the extent that there is unusually high time preference — that people really want money now. But assets that mature soon can also be illiquid in the sense of having low prices if you try to sell them when people suspect that you are cherry-picking (or, better, pit-giving) — that there is something wrong with this particular asset that makes it not a good proxy for its class — and the belief that there is something wrong with this asset can be triggered simply by your attempt to sell it.

I think that there is a big difference between me and Larry White in our view of what fundamental values are. You see, I start from something like a utilitarian’s dream — a belief that the rate of (safe) time preference ought to be on the order of 2% per year (2 percent growth in productivity times an elasticity of intertemporal substitution of 1) and that the equity risk premium ought to be on the order of 0.2% per year (the covariance of stock returns with consumption times a coefficient of relative risk aversion of 1). Thus if the market were working well — if we were using our financial markets to mobilize the full risk-bearing capacity of society — expected equity cash flows ought to be discounted at a real rate of 2.2% per year, Treasury bonds ought to yield a real rate of 2% per year, and every intermediate class of debt ought to have an expected value produced by a real discount rate in that extremely narrow range.

Thus practically every risky asset, all the time, sells for much less than its fundamental value — and does so because financial markets do not do a good job of mobilizing the risk-bearing capacity of society. I don’t think we have any prospect of living in a world in which financial markets do their job of risk-tolerance-mobilization well — nobody should trade or invest in anticipation of such a world. But I don’t think that the idea of “overinvestment” makes a lot of sense: the proper public policy response to every situation that White would characterize as one of “overinvestment” is, I think, one in which the government takes steps to mobilize more of society’s risk-bearing capacity rather than letting asset prices collapse and create massive unemployment.

I have to drop out of this virtual conversation now to take part in a real one in Vienna, but I will be back…

Also from This Issue

In the first of this month’s four accounts of the causes of the financial crisis, Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis, makes his case. White argues that the housing boom and bust, and the resulting meltdown of financial markets, cannot have been the result of a laissez-faire monetary and financial system, since we never had one. Nor can deregulation have been the cause, since the most recent relevant deregulation has probably helped contain the turmoil. While admitting that “private miscalculation and imprudence made matters worse,” White argues that “to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects.” He points to two such distorting sets of policies: the overexpansion of the money supply by the Fed, and government mandates and subsidies to write riskier mortgages.

In our second anatomy of the financial crisis, William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, says that key to the crisis was perverse compensation schemes that put the incentives of executives at odds with the interests of creditors and shareholders. Drawing on his concept of “control fraud,” Black argues that a failure of regulation encouraged executives to meet short-term earnings goals and to capture large bonuses by encouraging fraudulent mortgages – even when it could be foreseen that this might lead to the destruction of the firm. “When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud – and control fraud causes greater financial losses than all other forms of property crime combined,” Black writes. Fannie and Freddie cannot have been the culprits, Black argues, because they were guilty of less mortgage control fraud than their fully private counterparts. “ ‘Modern finance’ has failed the market test,” Black concludes. “Its policies optimize the environment for control fraud and create perverse dynamics that create recurrent financial crises.”

The housing boom and bust stands behind the financial turmoil of 2008. Therefore, in our third analysis of the financial crisis, University of Chicago economist Casey B. Mulligan explores various hypotheses about its underlying causes. Was it changes in tastes and technology? Public policy? Investor “exuberance”? Mulligan describes some of the empirical tests that would be needed to settle the question, and argues that at least part of the answer is already clear. Most of the housing boom, Mulligan finds, was based in expectations about the future, rather than in demand, supply, or subsidies during the boom. Mulligan says that additional empirical tests – especially about the aggregate wealth effects of the boom and bust – would help us form a more educated guess about whether boom expectations were based more to changes in tastes, changes in technology, or exuberance. But those tests have not been done, and therefore, Mulligan concludes we cannot yet reliably predict the future economic damage from the housing boom and bust, or formulate beneficial financial industry regulation.

Our fourth and final anatomist, J. Bradford DeLong, notes that “in the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion,” and lays out five reasons why this value might fluctuate. “Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements.” Therefore, DeLong says, we’re left with changes in the discounts for liquidity, default, and risk. The housing crash has increased default risk significantly, but central banks have actually pumped up liquidity. Almost the entire drop of the value of global capital, DeLong argues, comes from an “increase in the perceived riskiness … of income from capital.” The problem, DeLong says, is that “our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.” However, DeLong is confident that Larry White’s story – focusing on the money supply and government policy to encourage bad home loans – cannot be the right one.

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